Fitch Affirms Irvine Ranch Water District, California $70MM V-R COPs at 'AA+'.

SAN FRANCISCO -- Fitch Ratings affirms its 'AA+' rating on the Irvine Ranch Water District, CA's (the district) $70,000,000 certificates of participation (COPs) (2002 Capital Improvement Program). The 'AA+' long-term, unenhanced rating on the certificates is based on the long-term credit quality of the district.

The 'AA+' rating reflects the district's strong financial performance, low utility rates and revenue raising flexibility, exceptional long-range capital planning practices, and affluent and growing service area. Recent positive credit developments include the district's movement to increase its connection fees and ad valorem tax levies in order to fund growth-related capital, freeing traditional operating revenues to increase the funding of replacement infrastructure. As the district nears built-out in the next decade, its challenge will be to transition from a high-growth utility to one with a capital plan focused on the replacement of aging infrastructure. Credit concerns are limited, as indicated by the 'AA+' rating, and focus primarily on the district's imported water supply, which could be curtailed through legal or state action. The water supply matter is the subject of ongoing political and legal debates that have the potential to result in a significant decrease in availability to water utilities, such as the district, that purchase water supplies ultimately provided by the State Water Project (SWP). This could accelerate the need for the district to develop additional local water supplies, with the ultimate cost unknown.

The district provides retail water and wastewater services to an estimated 338,000 people within the City of Irvine (the city) and portions of five other cities and unincorporated areas in the county. Water supplies are derived from imported surface water purchased from Metropolitan Water District (MWD, rated 'AA+' by Fitch), local groundwater, managed by the Orange County Water District, (OCWD, rated 'AA+' by Fitch), and recycled sources from the district's wastewater treatment facilities. Purchases from MWD provided around 40% of the district's water supply in fiscal 2007. An ongoing legal case involving operations of the SWP, which constitutes 75% of MWD's water supply, may reduce Metropolitan's allocation from the SWP by up to 30%, which could significantly impact Metropolitan's water supply. This legal case is occurring within a broader political debate in California regarding the bay/delta and numerous environmental impacts affecting the region, including urban development, farming practices, deteriorating levy conditions, flood control, and state water consumption demands.

The district's groundwater supply is managed by OCWD. The cost of local water is substantially less expensive than the supplies purchased from MWD, however, the supply is limited and OCWD allocates the available supply among the local water agencies. The groundwater basin is essentially recharged by run-off from the Santa Ana River but OCWD does purchase approximately 30% of its supply from MWD and uses the water to replenish the groundwater basin.

The district has worked to develop alternative local supplies, primarily recycled water, which provided 15% of the district's water supply in fiscal 2007. The district has a goal to increase recycled water sources to 25% of its supply through additional extension of service. Approximately 80% of all business and community landscaping in the service territory is supplied by recycled water.

Wastewater treatment is provided both by the district (56% of wastewater collections) and by the regional provider, the Orange County Sanitation District (OCSD, rated 'AA' by Fitch). The district is increasing its own wastewater treatment capacity at its two treatment plants in order to treat more of the flow locally. Initial projections indicate this is more cost effective than continuing to pay OCSD for treatment services, given that entity's large capital plan.

The $70 million in series 2002 COPs represent the only senior lien obligations of the district secured by net revenues of the district. The district has offered a parity pledge of repayment on 12 reimbursement agreements with various letter of credit banks that secure the outstanding $225 million in general obligation (GO) debt of the district. The district also has $44 million in subordinate COPs outstanding. Repayment of GO bonds is secured by the district's ability to levy ad valorem taxes for the individual special districts within the district for which the debt was issued. Current levies are not sufficient to fully support the debt and the district does use its net revenues to pay debt service on the GO bonds, although this payment would be subordinate to the pledge securing the series 2002 COPs. Debt service coverage on the senior lien series 2002 COPs was exceptionally strong at 26.9 times (x) in fiscal 2006. However, the excess cashflow was used to support the GO bonds, resulting in all-in debt service coverage of 1.8x. Future debt service coverage levels are expected in a similar range. The district did increase its ad valorem levy and connection fees in recent years to provide more support for the GO debt and free excess net revenues for investment in the district's growing replacement capital needs.

Long-term forecasting by the district anticipates around $1.7 billion in capital funding through 2033, split between new facilities for growth-related projects ($670 million) and rehabilitation/refurbishment of existing facilities as the district matures ($1.1 billion). The district anticipates funding approximately 65% of this total through debt issuances, although much of the borrowing will be through additional GO bonds and the next COP issue is not anticipated until 2020. The district has a substantial replacement fund that is used to fund ongoing replacement projects. The balance in the fund was $145 million as of June 30, 2007. Although earmarked for capital, this fund provides substantial additional liquidity in addition to the other $34 million in unrestricted cash, or 169 days cash. The replacement reserve helps hedge the interest rate risk posed by the district's use of 100% variable rate debt. In addition to its $340 million in variable rate debt, the district has outstanding $140 million in fixed receiver swaps and $130 million in fixed payer swaps.

Not included in reserves are the full market values of the district's real estate holdings. The district sought special legislation in 1990 to allow it to invest in local real estate in order to hedge the risk of long-term inflation. Legislation allows the district to invest up to 30% of its replacement fund in real estate within Orange County. The district currently holds three active properties with a book value of around $39 million. In addition to ongoing annual revenues provided by the real estate holding, which are deposited in the replacement fund, the district estimates that the market value of its real estate holdings is well in excess of the book value.

The district maintains the flexibility to generate additional revenues through utility rate increases. District water and sewer rates for fiscal 2007 were among the lowest in the county averaging $23.86 and $13.65, respectively, for average residential customers. This is following a series of rate increases over the last five years. The district's service area consists of 179 square miles in central Orange County (approximately 22% of the county). The service area is characterized by high wealth and low unemployment levels and is close to reaching build-out. International business, technology, and research, anchored by the University of California, Irvine, provide the basis for the local economy. The district has increased its service area by 45% through the acquisition of four local water companies in the last decade. Capital costs associated with serving the new customers are allocated proportionally to those new customers. The additions have been small, in terms of customer numbers, so the impact on the district's existing water supply availability in the future has been minimal.

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